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Ratings downgrade

Updated: Earlier this afternoon the Senate passed Sen. Franken’s amendment to reform the credit rating agency process with 64 votes, including 10 Republicans. Of course, the larger financial reform bill has not yet passed the Senate, and there is no guarantee that this amendment will survive the conference process when the Senate’s version is reconciled with the version passed by the House in December of 2009, but proponents of the measure are hailing this as a significant step in the direction of reforming the credit rating agencies.

Credit rating agencies have essentially one clear and important role in the financial system: providing guidance, delivered in the form of ratings, on the creditworthiness of financial instruments. But over the past several years their performance has not exactly been worthy of a AAA rating — in fact it has been pretty dismal. So why do markets continue to seek and pay for the services of rating agencies? The short answer is: they have to.

The SEC designates Moody’s, Standard & Poor’s, Fitch and seven other smaller companies as Nationally Recognized Statistical Rating Organizations. Aside from sounding official, that designation is important because many laws and regulations incorporate these official ratings. For instance, certain types of banks are not allowed to hold below-investment-grade bonds, and some state and federal laws restrict the amount of below-investment-grade bonds that some investors, like pension funds, can hold.

Under normal circumstances this arrangement might make a lot of sense, but the past few years have been anything but normal for the financial system, and rating agencies have not fared well. Of nearly 12,000 residential mortgage-backed securities rated AAA by Moody’s of Standard & Poor’s, the two largest rating agencies, about one-third have since received a rating downgrade, some as quickly as six months after their initial rating. In 2006 and 2007, more than 90 percent of subprime-mortgage-backed securities were downgraded to below investment grade, or junk. According to the Senate Permanent Subcommittee on Investigations, which has investigated the role rating agencies played in the financial crisis, mass downgrades by ratings agencies “shocked the financial markets, triggered sales of assets … and damaged holdings of financial firms worldwide, contributing to the financial crisis.”

But despite this subpar performance and their prominent role in the financial crisis, very little has changed about the way that ratings agencies operate or their official status in securities laws. In order for a bank or financial institution to sell a bond, they need to obtain a rating, which they must, essentially, purchase from Moody’s, S&P or Fitch. So why hasn’t more been done?

Since the crisis, there have been some efforts at reform, including voluntary changes by the agencies themselves, like the addition of corporate ombudsmen. More significantly, the SEC bolstered several rules in September 2009, which now require disclosures of exactly what ratings cover, who paid for the credit rating and history of ratings actions like upgrades and downgrades. In July 2009, the Obama administration released draft legislation to strengthen disclosure and management of conflicts of interest and rules to bar firms from consulting with companies they rate.

Of the many problems with the credit rating agencies identified by regulators and commentators, few are considered as glaring as the conflict of interest presented in the model of having issuers pay for ratings. From the Senate’s investigation committee memo (pdf):

The fact that CRAs receive revenues from the issuers who pay for rating the products they sell creates an inherent conflict of  interest. Not only are CRA personnel encouraged by clients to provide them with favorable ratings, but the situation encourages ratings shopping, in  which an issuer can choose the CRA offering the highest  rating.

But despite all this momentum on rating agencies and the push toward financial reform more broadly, the ratings agencies have not been a key focus of reform. In Sen. Chris Dodd’s (D-Conn.) version of the bill there is a section on rating agency reform, but the structure of the industry would remain largely unchanged, including the way rating agencies are paid by issuers.

However, on May 4, Sen. Al Franken (D-Minn.) proposed an amendment specifically aimed at rating agency reform.

The amendment creates a Credit Rating Agency Board, “which would assign credit rating agencies to provide initial ratings in order to eliminate inherent conflicts of interest” according to a Franken press release. “The board would be made up of a majority of investors, a representative from the investment banking industry and credit rating agency industry, and an independent member”

By assigning the agency to do the work, the newly created board would ensure that financial institutions could not comparison shop for the best initial rating and rating agencies would have an incentive to provide accurate ratings, not just high ratings to appease issuers. The amendment would also have the effect of increasing competition by ensuring that all ratings agencies, including smaller firms, have the opportunity to compete based on the quality of their ratings, not their connections to financial services companies. Of course, a financial services firm would always be welcome to get a second rating from whichever firm they wanted.

Franken’s amendment has gained bipartisan support, but whether his reform actually makes the final cut could be determined in the next several weeks as Democrats push to complete financial reform.

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